Inequality: You Can’t “Fix-it-in-the-Fisc”

December 6th, 2011 at 12:31 pm

Commenter Greg raises a fair point about this sentence from this post:

Remember, and this is important as we move from diagnosis to prescription, the increase in inequality is very much a pretax phenomenon, and it’s neither realistic nor good policy to try to redistribute your way out of it.

To understand where I’m coming from here, let me introduce two concepts: the primary and the secondary distributions of income. The primary distribution represents market outcomes before the government gets into the game with taxes and transfers, like unemployment insurance or the mortgage interest deduction. The secondary distribution is the one that prevails once taxes and transfers are in the system.

Now, I strongly believe—and it’s one of the raison d’êtres of the CBPP—that the secondary distribution should be more equal than the primary one, i.e., that taxes and transfers should be progressive and that their impact should pushback on the inequities embedded in the primary distribution. This is particularly germane regarding blocked opportunities of the type that beset those stuck in low-income families, like access to quality education, safe, secure housing, and health care.

But the factors driving the growth in inequality are embedded in the market outcomes, and while increased progressivity can dull their edges and even counteract their longer term impacts (as just noted re access to opportunities), they cannot go far enough. Just think about the dynamics here: if, in a climate of increasingly income inequality, you punt on the primary distribution, then you will be depending on the largesse of the Congress (!!??##&!) to continuously increase the progressivity of fiscal policy. Good luck with that.

I’ve come to view this as a key point to understanding today’s self-limiting politics. The difference between typical Ds and Rs has diminished to the point where both basically agree that unfettered market outcomes should rip, even if they tear the fabric of society. D’s are just more willing to tinker along the edges of the secondary distribution, while R’s scream bloody murder as to how such tinkering will sink the whole operation. Neither side is much willing to go after the real culprit: the fact that the benefits of growth have become disconnected from the economic well being of most of the people helping to generate that growth.

I wrote about this here and included the figure below which shows how almost all the growth in inequality—measured here as the changes in pre- and posttax income shares—occurs before taxes. From that post:

Source: CBO

The fact that the growth in inequality is largely a function of the pretax income distribution doesn’t mean we should make it worse with regressive, supply-side tax cuts—(economist Alan Blinder calls this move “unnecessary roughness”—amplifying pretax inequality with regressive tax cuts). To the contrary, we need balanced tax measures to generate the revenues to support programs that can help push back on this trend—initiatives like Head Start, child nutrition, educational support.

But it also doesn’t mean we can meaningfully correct the problem with tax policy alone. We have be mindful of all the policies that effect the pretax distribution—the distribution of labor and capital earnings before any taxes and transfers kick in…that’s where the real inequality action is.

The post goes on to discuss the kinds of things I think will make a difference in generating more equitable—and more fair—market outcomes. But my point here is that while we need to fight as hard as we can to preserve and strengthen measures to offset the growth of inequality, our fights will be much easier if we address the underlying structural factors driving the increase in market-driven inequality.

Or, to put it another way, you should really use the strongest sun block you can find, but you shouldn’t expect it to turn back global warming.

10 comments in reply to "Inequality: You Can’t “Fix-it-in-the-Fisc”"

Your commenter’s post assumes that the primary, rather than secondary, outcome of taxation is to redistribute income, but it isn’t its fundamental purpose. The primary purpose of taxes is to raise revenue to pay for our services. Some that that includes safety-nets which may do some direct wealth transfer, but any examination of the budget shows that food stamps, EITC, etc. are a small part of the budget pie which is dominated by defense spending.

Very cool. Thanks for commenting on my comment Jared. Excellent. Just a quick follow up. When you write: “But the factors driving the growth in inequality are embedded in the market outcomes, and while increased progressivity can dull their edges and even counteract their longer term impacts (as just noted re access to opportunities), they cannot go far enough.”

I guesss I view the tax code and federal policy as one in the same. So, here it goes, is it fair to say that over the last 30 years market outcomes in the US economy were a direct result of tax policy changes and regulatory changes? Prior to the 1980s, top marginal tax rates and capital gains tax rates were high. Then, lo and behold, they were reduced radically. Is it fair to argue that market outcomes are a result of political decisions made in Washington.

Sure, Globalization, free trade agreements and technology altered market outcomes. But they couldn’t have done so without federal policy, correct? Not fully funding the SEC or enforcing laws already on the books had an impact on market outcomes. Isn’t it fair to say the Commodities Future Modernization Act of 2000 and the Financial Services Modernization Act of 1999 had a direct impact on market outcomes.

I’m interested in finding out where you see federal policy, (not just taxes) having an impact on market incomes, particularly when it comes to the $600 trillion derivatives market that didn’t exist in 1994.

Can’t market incomes be guided via tax policy? If there was an effective cap on income via a high income tax, I really don’t think that very many people would be paying it.

Imagine if there was a 90% tax on incomes over $150,000. Now imagine that you’re earning $149,000. You go onto a job interview, they offer you $155,000 in salary. Will you take the job based on the salary alone? Most likely not.

Likewise, imagine that you’re making $149k as a small business owner. You realize you can earn another $25k if you buy your widgets from China instead of Illinois. Are you going to do it? Probably not, because the extra profit isn’t going to you, it’s going to the government.

Salaries are not very flat right now. While that may be temporarily good for those at the top, this causes plenty of problems, especially in today’s specialized economy. For example, people get blown away when their sector of the economy shifts. Imagine going to school for 8 years to get your radiology degree, you operate as a radiologist for a few years but all of a sudden the jobs dry up because someone figured out that someone in India can read a chart as good as you.

Now what do you do? You were making maybe $140k a year, but there is no path for you onto another $140k/year career without starting from scratch – and virtually no one can do that. You’re just screwed.

Now if, instead of there being a small number of $140k/year jobs out there, there were a larger number of $90k jobs out there, the destruction of your job might not be so bad. Hey, maybe it causes you to try something different, maybe you are a budding photographer and you can make $80k in this profession.

Such cross-fertilization – profession-hopping – is a really good thing, because different perspectives are transferred across industries.

How many entrepreneurs are in the game for the money anyway? How many budding entrepreneurs would quit right now if the most they could make was $1 million per year? Are we really expected to believe that these guys would sit home on their couch instead of trying to bring their vision to reality. I don’t buy it.

Hey No Politician, nice post. Just a few comments. There was a time when we had a 90% top marginal rate, (in the 1950s), and I believe the wealthy kept on working. Of course the effective tax rate was much lower, but the point is this, the rich still did their jobs.

Re: your 149k small businessman and widgets from China, I believe we’ve seen this pattern repeated for 30 years. Getting taxed from the federal government didn’t prevent outsourcing, as business leaders viewed the reduction in labor costs far more important than any increase in marginal taxes.

Finally, for the most part, progressives in DC are talking about raising top marginal tax rates to the go-go Clinton era tax rates, so we’re talking about three or four percentage points for every additional 1,000; $30 for every additional $1,000.

I trust the animal spirits of a businessman or businesswomen to see the increase in the marginal tax rate as a small price to pay for a more civil society and less inequality.

The Government’s taxes and transfers can also be used to level playing fields by taxing companies who harm their workers and their competition.

For example walmart uses the taxpayers to subsidize their employees wages by paying below poverty wage allowing their workers to use government programs meant to help the poor. This is a huge advantage over other stores who want to pay their workers a fair wage.

Thanks Jared for all of your efforts to keep this discussion out in front; how this is decided is so critical to the kind of country our children, grandchildren, and subsequent generations will live in that its importance can’t be overstated. Its great to see the honest and accurate presentations you make showing how completely out of control this has gotten; it would be nice to see more discussion of how long it will take to 1. stop the current progression of these destructive events, and 2. to return the country to reasonable levels of income, wealth, and opportunity equality that are consistent with views of this country as “the land of opportunity,” as well as a “meritocracy” instead of the current oligarchy and “land of the lottery winners” that it has become.

Like Gregg, I’m finding it difficult to understand why it is that redistribution to correct these “arbitrary and inequitable” distributions of wealth and income (in Keynes’ words) is either unrealistic or bad policy. In fact, considering our current circumstances, it seems that we are now at point where redistribution is the ONLY realistic policy tool we have to correct this situation within one or two generations. It also seems that there are two key factors that are standing in the way of implementation of these corrections: 1.) campaign financing laws that allow our government to be controlled by the wealthy minority that wishes to maintain the status quo and prevent our government institutions from being truly representative bodies; and 2.) dissemination of the misinformation that this level of inequality is a.) not the harmful, destructive force that it is; and b.) the product of “natural” market forces that shouldn’t be tampered with because they will produce “inefficient” outcomes or make us “less competitive” somehow in the world economy.

Dean Baker’s new book “The End of Loser Liberalism” does a great job of explaining how these “market outcomes” that are claimed to be the “natural” workings of an “efficient” economy that result in the outcomes you identify as “the primary distribution” which “represents market outcomes before the government gets into the game,” are in fact largely the result of government interventions into the “free market” and have little in the way of “natural” underpinnings. Thus the government is “in the game” from the very beginning and there is no logical reason why the government should not intervene to alter the “arbitrary” outcomes at any point later in the process. Legal decisions often hinge on the “burden of proof” and it may well be time that we shift the “burden of proof” in economics to those who push for allowing this inequality to continue and away from those who suffer from its consequences (the other 95%). There’s more than ample evidence to show that extreme wealth and income inequality have terribly destructive consequences, we have tools to measure it (i.e. Gini), and can manage it through wealth, estate, and income taxes. Where’s the evidence that there’s any benefit at all (let alone a net benefit) to have a wealth or income Gini > .5? Maybe we should set this as the upper limit until proponents of a higher limit can “prove” that there is some net benefit to the country of allowing this to go higher? The recent study done by Diamond & Saez showing there’s an optimal tax rate http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.25.4.165 provides ample evidence that our marginal income tax rates (and discussion about these rates) are a long way from this “optimal” level. Its likely that there is also a similar “optimality” to wealth and income concentrations and yet there is virtually no serious discussion being conducted about how to manage it.

So why is it that government policies that would benefit of 90% + of the population “unrealistic” and beyond our current policy discussions? Maybe we should see if history has any lessons for us that show how these types of impasses usually get resolved.

I too would like to see a return to very high tax rates on very high incomes. Maybe we need additional strategies to reduce primary distribution inequality, but wouldn’t very high marginal rates serve as a strong incentive to redistribute profits into workers further down the pay scale, improving facilities, and product research and development?

I believe it would also reduce the incentive to outsource, since executives would profit less from taking for themselves the fair wages and benefits they would otherwise pay American production workers.